Huge changes for Ethereum are on the horizon, larger than most of the upgrades we have seen since the network’s launch in July 2015. We have Eth2, EIP 1559, and increasing adoption of Layer 2 scaling solutions in prominent Ethereum protocols.
The main motivation for these changes are to increase Ethereum’s scalability, manage network congestion, decrease the inaccessibly high gas fees, and increase network efficiency. These highly awaited changes come in the backdrop of surging demand for Ethereum dApps (in particular DeFi and NFT dApps) that have outstripped Ethereum’s capacity. This has led to surging fees and the increasing success of competing chains like Solana and Binance Smart Chain
(Check out my competitive analysis of Binance Smart Chain and Ethereum).
While that is what most of us focus on and look forward to, it is interesting to understand how these infrastructure developments influence ETH tokenomics (and price). Here, we give an overview of these infrastructure changes, their timeline, and potential effects on ETH tokenomics and price in the short and long term. This article hopes to:
Given the article’s length, feel free to skip parts you’re familiar with.
What: Eth2 can be broken down into 2 main upgrades: Proof-of-Stake and sharding
Separate from Ethereum’s mainnet, the Beacon Chain’s setup is the first step for Eth2 upgrades. It introduces Proof-of-Stake (PoS) to Ethereum and lays the foundation for a transition away from the current Proof-of-Work (PoW) system.
Under PoW, blockchain transactions are verified by miners who solve cryptographic problems that require high computational power and energy. The first miner to solve the problem creates a block and is rewarded freshly minted ETH. Meanwhile, in PoS, users stake and lock in 32 ETH to become a validator, which creates and validates blocks like miners under PoW. However, they do not compete to solve a problem, but are rather chosen at random to create blocks and receive rewards. Rewards are thus received in proportion to the amount of ETH staked.
This reduces energy consumption of the network, supports decentralization by reducing expensive hardware requirements and encouraging the creation of more nodes, and makes the network more secure as significant amounts of ETH are needed to launch an attack. This tackles the security and decentralisation aspects of the blockchain trilemma. The scalability aspect, meanwhile, is addressed by Eth2’s sharding.
Graphic visualisation of sharding, from Quantstamp
Sharding splits large databases into smaller parts called shards. This increases scalability as validators do not need to store data for the entire network, but just for the shard they are allocated to. Currently, Eth2 plans to have 64 shards, with the Beacon Chain coordinating inter-shard communication. There is still a debate on whether shards should simply act to provide extra data or if they should also have code execution functionality.
Timeline: the Beacon Chain was launched in late 2020. We have sharding on the roadmap for 2021, to be introduced to the Beacon Chain, before it is finally merged with Ethereum’s Mainnet in 2022. At that stage, the pre-existing old Ethereum chain would simply become one of the many shards in the network.
Under the current PoW system, rewards stand at 2 ETH per block and 1.75 ETH per uncle block (created when more than one block is mined at roughly the same time, as only one block can be validated and added to the ledger). Note that rewards were previously higher before February 2019. With an average block time of ~13.15s at the current mining difficulty level, the annual issuance rate stands at ~4.5%.
Under Eth2’s PoS, the issuance rate is dramatically lower and is expected to range from 0.5% to 1+% based on some reasonable assumptions. It is hard to give a precise rate since issuance is dependent on a number of factors:
Nevertheless, issuance rate is expected to decrease dramatically.
Overall, Eth2 causes a short term increase in supply rate during its trial phase, before merger with mainnet, as both PoW and PoS systems issue ETH. However, post-merger, Eth2 would lead to a significant drop in supply rate.
What: EIP 1559 changes Ethereum’s fee structure and introduces fee burning
These changes reduce the need for users to guess the gas price needed for their transaction to be included, leading to a more efficient fee system and less fee overpaying compared to the first price auction model.
Timeline: to be incorporated with other EIPs in July 2021’s London hard fork
Burning of base fees decreases ETH’s supply in proportion to the amount of activity on the Ethereum network as base fees increase to meet the 50% block size target when the network is congested. Estimating the magnitude of the effect is difficult since it’s heavily dependent on network activity. Taking current transaction fees as a proxy is also not fully accurate as we are unsure of the base fee-tip split. Some estimate that EIP 1559 will heavily reduce net issuance to the point where ETH becomes deflationary.
What: These solutions do not change the underlying Ethereum infrastructure (Layer 1). Rather, they reduce network congestion by handling some transactions off-chain. Besides helping with scaling, some solutions provide privacy in an otherwise open blockchain world where all transactions are public.
We refer to them as non-L1 scaling solutions as some of the solutions (eg. side chains) are technically not Layer 2, as they are not directly secured by Layer 1. Here is a brief overview of some scaling solutions:
Timeline: prominent dApps have adopted scaling solutions. Some examples:
Before EIP 1559’s implementation in July 2021, scaling solutions would not really affect ETH supply. However, as these solutions are linked with network activity and transaction fees, interesting dynamics emerge when EIP 1559 bridges the gap between fees and ETH supply. Here are some possible effects:
It is hard to ascertain the net effects which could also change over time. Net effects depend on:
These changes are likely to lead to an increase in ETH demand and fiat inflows into ETH as they attract investors by:
Diagram on the effect of Ethereum infrastructure changes on ETH supply and demand. Arrows indicate expected change over time and box size indicates uncertainty
Explanation of the expected timing and speed of vertical/ horizontal movement of ‘Eth2’ and ‘Scaling Solutions’ on the previous chart
Here is a brief summary of the positioning of the 3 elements in the chart:
The chart and our discussion point toward the fact that Ethereum’s infrastructure changes have created strong tailwinds for ETH price by exerting pressure on both the demand and supply side. However, with ETH breaking all time highs constantly, many are left to wonder how high ETH can reach and if these tailwinds have already been priced in.
My personal take is that even if ETH does go through more crazy booms and busts, it would be worth more than it is now 10 or 15 years down the road. My 3-step reasoning:
*This does not constitute investment or financial advice.
Thanks to Casper Bjarnason for giving feedback on this article.
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